Many Republican candidates have proposed eliminating the capital gains tax as a means to drive economic growth in the United States. This belief stems from Ronald Reagan's success in the 1980's. However the world has changed significantly since the 1980's and the factors that resulted in success for Reagan no longer exist. In fact, reducing capital gains may result in a net decrease in US job growth.

Problem 1) The Portfolio Effect

In 1980, US investors had their complete portfolio invested in US stocks and bonds. The leading edge Harvard University Endowment fund allocated 66% to domestic equities and 34% to fixed income. By 2010, the Harvard Endowment fund had shifted it's asset allocation to 11% US equities, 22% Foreign Equity, 12% Private Equity, 23% Real Assets, 15% Fixed Income and 16% Alternative. Harvard's current allocations more closely align to international equities 50% share of global market capitalization. Portfolio investment in developing economies (that is, net purchases of securities by foreigners, typically American and European financial institutions) increased from zero in 1980 to well over $100 billion in 1993 (World Bank, 1999). The Institute of International Finance is projecting further increases in overall net private capital flows to emerging markets this year to more than $1 trillion, following a 54% rise to $990 billion in 2010.

However, the average US investor has been slow to move into these markets. According to various market surveys, international equities represent only approximately 11% of the typical institutional plan sponsor portfolio. Reasons for this lag include: the perceived higher risk of emerging markets, higher investment costs and portfolio switching costs. Eliminating the capital gains tax will mitigate many of the barriers and investors should significantly increase their share of international equities. As investors shift 14 to 30% of their portfolio into international equities, US capital markets will tighten near term constraining new investment and job creation. In addition, the deficit will increase as we lose capital gains revenue but fail to gain the investment related revenue. This rising deficit will further squeeze capital markets and hinder US job growth.

In 1990, there were about 600 hedge funds worldwide with assets of approximately $38 billion.6 In Reagan's time in 1980 it would have been less. Including performance gains, we estimate current industry assets under management (AUM) remain at $1.5 trillion as of June 30, 2010.7 Hedge fund managers get paid by taking 20% of the capital gains enjoyed by the fund. Although the equity comes from others, hedge fund managers pay capital gains taxes on this income.

As you drop capital gains taxes to zero, the spread widens between income taxes owed and capital gains taxes owed. The spread is significantly more than in Reagan's time when he actually lowered the spread. Product industries, which create jobs for others, struggle to compete with the hedge fund industry for the best and brightest minds. The best product industries can offer are ISO's (incentive stock options). These options are also completely taxed as capital gains but they are limited to $100K a year. The $100K a year in tax free income pales in comparison to the tax free income available at hedge funds and US industry loses key talent and fewer jobs are created.

Acquisitions have increasingly been in vogue among major corporations. Companies are acquired for many reasons. One common reason is the ability to acquire assets while also improving the acquired company's gross margins. This improvement is often done is by replacing the on-shore back office operations in human relations, accounting, support, and marketing services with cheaper off-shore labor. In Reagan's time this wasn't possible. A long-distance telephone call that cost 25 cents a minute in the 1980s can now be had for fractions of a penny.

Major companies have played the labor arbitrage game to significant advantage within their own companies and are now extending it to mid-size firms by aggressively acquiring them and off-shoring back office employees. By eliminating the capital gains tax, Congress will only speed up this process. Studies by Benjamin Ayers at the University of Georgia show that capital gains taxes represent significant transaction costs or market frictions that influence the level of corporate acquisition activity. By eliminating these costs, more deals will be completed and more jobs will be off-shored.

Your basic argument is that more efficient use of capital will result in less economic activity.

Did you ever take Econ 101? Did you pass?

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No my basic argument is when you reduce the capital gains tax it will cause portfolio investment to shift overseas and will increase the rate of labor arbitrage plays both will cause US jobs to decline.

I think you have missed the point or didn't read the posts. Instead of creating jobs eliminating the capital gains tax could instead cause us to lose jobs.

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Or they just didn't buy that crap. Liberalism is the magic elixir that magically solves all problems. Yet Obama hasn't solved a single one. Basically liberalism comes down to pick something that you want to do, pick something you want to happen, claim what you want to would lead to what you want to happen, and when it doesn't say you didn't do enough of what you wanted to do. Then repeat over and over.

Your basic argument is that more efficient use of capital will result in less economic activity.

Did you ever take Econ 101? Did you pass?

Click to expand...

No my basic argument is when you reduce the capital gains tax it will cause portfolio investment to shift overseas and will increase the rate of labor arbitrage plays both will cause US jobs to decline.

I yes I did quite well in Econ and Finance.

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Well, that's because you didn't make arguments like this when you did it. The Rabbi was correct, your basic argument is more efficient use of capital will result in less economic activity and it's ignorant. I don't have to have a degree in Finance to know that, I just have to not be an idiot. Though bonus, I do have an MBA, I'm in the Financial Management Honor Fraternity for my Finance grades and I spent a good chunk of my career in finance. You lose on logic, but if you want to trot out degrees I'm game as well.

The OP was thought provoking in that there are major difference in Capital Markets between now and the Reagan years. One can argue over the degree of difference a cut in Cap Gains would have. The OP seems to go far off into the void on it but I think that any meaningful cut to Cap Gains tax would be stimulative to economic growth

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